Today I have a guest post from Joeseph Sheeley. Joseph Sheeley (aka SmallIvy) is the founder of The Small Investor. For more than ten years he has been writing articles on investing, money management, and the methodology behind becoming wealthy. He is the author of two books on investing and money management, The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy and FIREd by Fifty. He will have a third book, Investing to Win, The SmallIvy Book of Investing, Book 2 published this summer. He is a personal investor, having invested/speculated in stocks, bonds, mutual funds, commodities, options, and other financial instruments for more than 35 years. He is a rocket scientist by trade.

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Everybody likes volatility when things are going up. Unfortunately, into each life some rain must fall, and between every pair of bull markets there must come a bear. To be a good investor, you must learn both how to craft your portfolio to deal with the inevitable downs that will eventually come. You also need to learn how to sustain corrections and bear markets without losing your head and selling everything. To quote investing coach, Paul Winkler, “You only get hurt on the rollercoaster if you jump off.” Today we’ll discuss the strategies for both limiting the effects of volatility on your investing and helping you fight the psychology to fight the fear and greed cycle that ruins most investors’ returns.

Volatility is good

Most people hate volatility, at least when it is going against them. But volatility is actually a really good thing. In fact, it is volatility that makes investing possible. Things we invest in – stocks, bonds, real estate – all have returns that are somewhat unpredictable. If you were to buy any of these assets today, you would not be able to tell me with any certainty what price you would be able to sell them for in a week, a month, or a year. This is because the price someone is willing to pay you changes all of the time based on a variety of factors. Their near-term price seems random, and that’s what volatility really is: randomness in price.

Let’s say that I were to ask to borrow a dollar from you today and would give you a specific amount of money – some amount you specified – tomorrow. Let’s first say that I will actually put the amount I owe you in an envelope and let one of your friends hold onto it for the night. You would know exactly how much money you would have tomorrow (assuming I’m not some sort of illusionist and you have a friend can trust). How much would I need to give you? A dollar back? Maybe a dollar ten to make it worth going without the dollar for the night? You would know that you would get your money back. Also, the amount you’d be risking – a dollar – isn’t that much, so if I were able to scam you somehow you wouldn’t be out much. You wouldn’t be taking any risk, so you wouldn’t need a good return.

Let’s now say that I want to borrow $1000. Let’s also say that I want you to send the money to me in a foreign country. You’ve never met me and don’t really know anything about me. You’d probably think it was a scam. But let’s say I offer to send back $10,000 for the overnight loan. Or $100,000. Or $100M. I guarantee there is some amount of money I could offer that would make 99% of people take the offer. Even though you would be taking a substantial risk and the amount of money you would be risking was substantial, at some point you would decide the reward was worth the risk. You would be even more likely to do the deal if you knew other people who had done similar deals with me and ended up getting the reward promised.

So, because you can’t predict the exact return, you are taking a risk. You will only do the deal if you will be suitably rewarded for the risk you were taking. The bigger the risk, the amount you (and everyone else) would expect to get as a reward.

If you buy a single stock, a single bond, or a single rental property, and hold it for a year, there is a substantial risk of losing money. You wouldn’t do it if you got the same sort of returns you could in a bank where you know exactly what you would receive in return, but people can and do because the rewards can be substantially more. Because these investments are volatile, people can get returns that are a lot greater than they can get for a sure thing. And this isn’t just by accident. Investments like stocks are priced so that when things work out, the gains you realize are worth the risk taken. And you don’t need to worry about getting a good price since, by using an auction market where thousands of bidders constantly make offers, the prices set are always adjusted to take risk into account.

But just because you will be compensated for the risk you take when things work out doesn’t mean that things will work out. If you were to pick a stock at random (or even if you were to do some research) and hold it for a year, your chances of seeing the price rise or fall are about equal. The same is true if you were to buy an empty lot in your town, especially once you’ve taken inflation into account and paid property taxes. Even if you bought a bond, changes in interest rates or just perceptions about the company that issued the bond could cause the price to rise or fall. 

But it is possible to invest in such a way to make it very unlikely that you will lose money, but buying something for a year is not the way. In fact, it is possible to predict your returns, at least within a reasonable range, and almost guarantee that those returns will be substantially better than you would get at the bank, if you invest the right way. How is this possible? Let’s look at a computer game from the 1970’s to understand.

Lemonade Stand

In the late 1970s a few people had computers, but they didn’t know what to do with them. To fill the need, a computer game called Lemonade Stand was created. In this game, the player ran a lemonade stand for a period of 30 days. Before each day, the player would choose how much lemonade he would make and what he would charge per glass based on the weather forecast, which was right maybe 50% of the time. If it was sunny and hot, he would sell lots of lemonade even if he set the price fairly high, maybe all that he made. If it was rainy, he’d only sell a few glasses or none at all. His profit for the day was the price per glass times the number of glasses minus the cost of supplies. The game was text based – no real graphics to speak of. 

The game used a random number generator, so the weather and therefore your sales was a roll of the dice. There was a lot of volatility. If you were to just buy supplies for say 30 glasses of lemonade and set a moderate price for one day and see what you could sell, you might make or lose money. The same was true if you played for three or four days the same way. If you played this way for all 30 days, however, you would make money almost every time and if you played the game several times this way, you would find that your earnings would fall within a range. If you were able to set the game to play for 60 days instead of 30 days, the range of returns would get even tighter. Once in a great while you might get really unlucky and see three of four rainy days in a row right at the start of the game and end up losing all of your money and not have money to buy supplies to complete the game, but this might happen one in a thousand times. 

What we’re doing is dealing with the randomness of the returns by playing for several days. While it might be about 50-50 whether you would make or lose money over any one given day, by playing for several days the good days erase the bad days. Because there are slightly more good days than bad days, we end up with a profit at the end most of the time. We can do the same thing with investing. Since the assets we’re buying – stocks, bonds, and real estate – all have an upward bias, if we invest for a long time, we’ll see our investment grow almost all of the time.

Buying multiple lemonade stands

If you were to buy a single stock, like stock in Amazon, your chances of making money would increase if you held it for a reasonable period of time, like five to ten years, over your chances if you held it for only a week, a month, or even a year or two. But it is still possible that something could happen to Amazon. There could be a huge scandal, there could be a big lawsuit, or Congress could decide they were too big and break them up. Even though they may seem invincible, things do happen to big companies. In the 1980’s, Sears and Kmart were both huge companies. Today, even combined together, they are insignificant in the retail area. The longer you hold a single company, the more likely it is that they will fall apart. You could also buy a single rental property and see it wiped out by a flood or black mold. This is known as single asset risk.

Even if the stock you chose didn’t decline in value while you held it, it might not grow as quickly as the average stock in the market. The piece of property you buy might not rent out very well or appreciate like other properties in the area or the nation. Again, which one does well and which one falters is somewhat random. If people could predict which company will do really well over the next ten years, they would bid the price up. Because of the auction system, the price you pay is the best guess from people in the markets of what price should be paid right now to get a reasonable return in the future. If they thought it would go up 1000% over the next year, they would bid the price up something like 995% today.

So, how do you deal with not knowing which stock or property will do well? You buy several of them. Just like holding for longer periods of time makes your returns more predictable, so does holding more securities or properties. The more you buy, the closer you’ll get to market returns. And the market returns for stocks, bonds, and real estate are all positive and all substantially better than bank rates. With stocks, the easiest way to buy a whole bunch of stocks is to buy a mutual fund. Furthermore, if you buy a special kind of mutual fund called an index fund, your fees will be really low, which generally increases your returns. Because most index funds buy a specific segment of the market, you buy several different index funds.

What kind of assets should you buy?

So if you have the choice of stocks, bonds, real estate (individual properties or through Real Estate Investment Trusts-REITs), which do you buy? And what kind do you buy of each asset? In stocks there are small, medium, and large; retail, technology, services, banks, etc…; and you can invest in the US, Asia, North America, South America, Africa, India, etc…. In bonds there are corporate and government bonds, short term and long term bonds, junk and investment grade bonds, etc…. In real estate there are apartment buildings, homes, businesses, strip malls, open land, and even storage sheds and cell towers.

The answer is that you 1) choose the asset type that has the most volatility, but that has a predictable return for the time period in which you have to invest and 2) buy all of the different asset types that meet that criteria. So, if I were to have 30 years to invest, I would put everything in stocks and real estate since both are equally volatile and have about the same returns, but both have returns that are positive and fairly predictable if held for 15 to 20 years or more. I would buy all types of stocks, big and small, US and from different countries around the world, and different types of real estate. Any one of these types of assets could be the best performer at any given time, and I don’t know which one it will be, so I just buy them all.

If I only had ten years to invest, I wouldn’t put so much in stocks and real estate because returns would be too unpredictable over such a short period of time. We could see a big bear market that takes everything down, so I might not get a very good return over the period. If I really, really needed the money in 10 years, I would put a great deal of the money into bonds of different types. I might also include some high quality stocks and REITs, but stick to ones that aren’t super volatile and therefore would still have fairly predictable returns. If I only had a year before I really needed the money, I’d suck it up and just buy bank CDs since that is the only asset type where I could predict the returns over a year.

Because my returns would be higher if I invested in more volatile assets, I’d choose the most volatile assets. Because I would want to be almost certain of making money, however, I would only buy assets that were very likely to have a predictable return (within a range) over the time period I had. I would choose different types of assets of equal volatility because they would probably not all move in the same direction at once very often, so the volatility of my portfolio overall would be reduced. I would probably get the same returns if I were to buy just one kind of asset as I would by buying several different types if I held for the required period of time, but my portfolio value would fluctuate a lot more that way than if I bought different types of assets. I would not be getting any additional returns for holding through those ups and downs, so I’d choose to mix asset types together and reduce this unhelpful volatility. 

Now, if I were investing money from a first job at age 16, and I was investing for retirement or maybe a home in twenty years, I would pick all stocks and probably slant towards small stocks. Small companies are more volatile, so their returns are better over long periods of time than large stocks, so I’d choose them since I was young and didn’t need the money soon. I’d also know that I would be getting a job that paid a lot more in a few years once I had more experience and maybe a college degree, so I would figure I could take the risk since if I did suffer a loss I could easily replace it with my larger future income.

Disclaimer: This article is not meant to give financial planning or tax advice.  It gives general information on investment strategy and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.